Bfm newsletter 10_2011

How to Pick Better Mutual Funds?
* PEOPLE + PROCESS + PHILOSOPHY = PERFORMANCE * October, 2011

Dear friends, You should decide to be either patient with
active managers or seek a passively managed
If you have the time, desire, experience and approach. The vast majority of long-term top
knowledge of building your own investment and performing managers will endure periods of lousy
retirement portfolios, this newsletter is for you! performance.

At BFM, we are very analytical and we believe · 85 percent of all ten-year top quartile funds
that asset allocation is more important than spent at least one three-year stretch in the bottom
stocks or mutual fund selection… but many of half of their peer group (they spent about 23
you have asked us to share our disciplined due percent of all their three-year periods in the
diligence process to selecting investment bottom half of their peer groups).
managers and mutual funds.
· 62 percent of ten-year top quartile funds
Selecting a good mutual fund is extremely spent at least one five-year stretch in the bottom
difficult. Only 20% of funds may outperform half (19 percent of rolling five-year periods in the
their benchmark over the long run. 40% of funds bottom half of their peer groups). Source DiMeo.
that were in business 10 years ago are now gone.
A fund can be at the top one period and be at the Short-term greed and impatience will lead
bottom the next one. investors to fail. Before investing you should
develop confidence in the fund and the
As you can see, mutual fund returns can be very patience required for long-term success.
different (international fund category). Otherwise, you should invest in index and passive
funds (low costs).
10-year Value of
Name Return $10,000
“Do not wish for quick results, nor look for small
advantages. If you seek quick results, you will not
Old Mutual Copper Intl Sm Cap 50% $14,988 attain the ultimate goal.” Confucius.
Invesco International Sm Cap 417% $51,716
Human emotions are the biggest obstacle to
investor success. Proper research goes well
beyond the numbers. It also requires regular
The debate between active and passive meetings or calls with the managers. Natural
management (investing in index, passive funds human behavioral tendencies during the manager
and ETFs) is a constant discussion among selection and termination process generally leads
individuals in the financial world. There are to failure so we recommend a rigorous process.
qualitative and quantitative factors that need to be We believe that qualitative metrics for selecting
understood and analyzed correctly before picking mutual funds are as important as quantitative
a good fund. metrics.

© 2011 Bourbon Financial Management, LLC ~ All Rights Reserved ~ Info@bourbonfm.com ~ (+1) 312 909 6539 1

What traits and factors do we look for, review Such data may not available by directly looking
carefully, and monitor constantly? into sources like Bloomberg, Morningstar, and
Lipper. This requires contacting every fund and
Qualitative factors: requesting them to provide the data.
1. People: education, qualifications, experience,
depth, stability, diversity, quality and diligence
of the investment team (portfolio managers, Quantitative factors:
analysts, traders, auditors…)
1. Fees*/ Expense ratio: Funds in the cheapest
2. Investment philosophy that is consistent, quintile were more than twice as likely to beat
clearly articulated and understandable the average for their categories than the most
expensive quintile
3. Investment process and style based on
meritocracy that are transparent, repeatable, 2. Tenure / Experience / Track Record of the
consistent, and definable with good buy and Portfolio Managers and Analysts. The average
sell discipline and risk management tenure maybe close to 6 years only…
procedures
3. Fund ownership** by the portfolio
4. Stewardship: a corporate culture of management team
excellence, with clean regulatory history,
board integrity, independence, ownership and 4. 5 and 10-year Information Ratio (IR) and
compensation who will put your interests first peer ranking. The IR measures the risk-
adjusted return for assessing the performance
5. Firm ownership structure of active portfolio managers
6. Manager compensation and incentives 5. Long-term after tax return / performance:
structure (salary, bonus, stocks, shares…) that GMO Emerging Country Debt had a 10-year
reward individual contributions annual return was 14.54% ($10,000 became
$38,880) but after tax, the post-tax return was
7. High conviction approach that is distinct and 9.80% ($10,000 became $25,468 or 35% less)
with potential to outperform. “Worldly
wisdom teaches that it is better for reputations 6. Consistency of portfolio returns with the
to fail conventionally than succeed investment process (attribution reports)
unconventionally.” J. M. Keynes.
7. Funds concentration
8. What percentage of research is generated
internally (vs. sell-side research from Wall 8. Tracking Error and Active Share: these
Street)? numbers represent how much the fund
returns deviate from the benchmark
We also review the portfolio composition, size
9. Beta and Correlation with the fund’s true
(small or large cap) and style of the funds,
Benchmark (R square)
manager concentration, and if a manager has
closed a fund to new investors in the past and ask
10. Inflows/Outflows and total assets in the fund
how they decide to close it in the future.
today and 5 years ago


11. Up/Down capture ratio and maximum
drawdown
*: Of domestic stock funds, 47% in the cheapest
12. Sortino Ratio which measures the risk- quintile beat the average over a 10-year period,
adjusted return while just 19 percent of the most expensive
quintile beat the category average. The cheapest
13. Volatility quintile of domestic-stock funds survived and
beat the cheapest index fund 29% of the time,
compared with just 17% of the most expensive
14. Turnover which measures the number of quintile. There is a high correlation between
times securities/shares are replaced/traded costs and survivorship, as high-cost funds have
a large attrition rate. Looking at rolling 5 and 10-
year periods for US stock funds, the cheapest
group had an attrition rate of 13% over 5-yr
The quantitative data is available from a variety of periods and 25% over 10-year periods. The
sources like Morningstar, Lipper, Bloomberg, attrition rate for the most expensive group was
fund prospectus, fund statement of additional double that: over 5-year periods, 29% of the high-
information, shareholder reports, fund cost funds had merged or liquidated and 49% had
companies… merged or liquidated over 10-year rolling periods.

You can see that these lists could include many
more factors. Also important is that these factors
**: We like managers to have skin in the game.
are not available easily. You need time and a
Does your Manager eat his own cooking? Would
good network to obtain all the necessary you invest in a fund when its portfolio manager
information. does not even invest in it? 46% of the US stock
funds managers report no ownership! 59% for
It does not end there. You may want to look at a international foreign funds managers. This
fund's correlation with other assets/funds in your information can easily be found at
portfolio to optimize your portfolio risk level and www.morningstar.com/goto/fundspy or in the
decide what capital allocation would be best to fund prospectus (statement of additional
minimize your downside risk. Short-term information. Higher investment levels aren’t a
performance is not important. guarantee of success or an ethical manager, but it
shows that managers believe in the funds.


DETAILS

Investment knowledge is imparted by investment
and finance professionals. These professionals
The world is a mix of different professionals. include individuals with professional degrees like
Every professional has his or her own duty to an MBA, Masters, CFA, CFP, CPA...
perform well, be it as a teacher, mechanic or
bartender. Many times individuals try to But in spite of the experience and education
experiment with ideas outside their expertise. professional investors possess it is difficult to
There is nothing wrong in learning new ideas; attain the highest skills in all the different
they rejuvenate you and can bring a fresh investment arenas. So, being a common person
perspective to your daily routine. But what is who does not work intensively in the world of
important is that you should not be over finance, you can see the complexities in making
confident in pursuing activities beyond your investment decisions.
expertise. For example, practicing skydiving
without a professional skydiver or dancing Ballet
without a ballerina’s guidance can harm your
body.
What Are Mutual Funds?

A mutual fund is a company that pools money
Investing your wealth, just like skydiving and from many investors and invests the money in a
ballet dancing, is an art. Investing without combination of stocks, bonds, and other securities
knowledge is like jumping into a valley or assets. The combined holdings that the mutual
without a parachute. fund owns are known as its portfolio. Each share
represents an investor's proportionate ownership
of the fund's holdings and the income those
There are two main categories of investments: holdings generate.

 Equity
 Fixed Income


Which Strategy to Choose: Active vs. Passive Management?

Passive Management is an investment strategy Active Management, on the other hand believes
that attempts to replicate the returns of an index the market can be inefficient sometimes.
or benchmark by owning the same assets, in the Managers attempt to add value over the returns of
same proportions, as the underlying index. Passive an index by picking assets based on models,
investing does not seek to capture any excess insights, and analytical research. Managers aim to
returns, but rather tries to match the performance achieve a higher return then the benchmark by
of the index. Indexed Mutual Funds and ETFs are selecting a superior stock, currency, market, or
common vehicles used for passive investing. sector, etc. Active managers will try to exploit
pricing inefficiencies to obtain excess return.
(Source: SPDR University).

Percentage of Active Funds are Underperforming the Benchmark

Efficient wealth management is a tedious and large-cap value and large-cap growth, all the other
time-consuming activity. It requires a categories have more than 75% of the funds
psychological self-understanding along with underperforming the benchmark.
excellent analytical and technical skills. Here we
look at how actively managed mutual funds have By looking at the numbers we can say that
performed across the years compared to their selecting a good mutual fund is extremely
respective benchmarks and the numbers are very difficult. Thus, effective organized financial
surprising. planning is important. The finance professional
cannot guarantee above average returns but some
The figures below are Equity and Fixed Income of them will be more adept and skillful in
mutual funds style boxes after adjusting for managing investments than a layman.
survivorship bias. We see that all the categories
have more than half of the funds
underperforming the benchmark. Also, except for

EQUITY FIXED
% below Value Blend Growth INCOME
benchmark % below
Government Corporate GNMA
benchmark
Large 56% 83% 73%
Short 94% 99% 100%
Mid 99% 96% 98%
Intermediate 80% 91% N/A
Small 84% 93% 76%

Sources: Vanguard calculations, using data from Morningstar, Inc., MSCI, Standard & Poor’s, and Barclays Capital


Why do active managements underperform active managers outperformed the relative indexes
benchmarks so poorly? An indexing investment only in three asset classes—small cap blend, small
strategy performs favorably in relation to actively cap growth, and international as shown in the
managed investment strategies because of figure below.
indexing’s low costs, broad diversification,
minimal cash drag, and, for taxable investors, the Research conducted in the 1960s by Jensen
potential for tax efficiency. Combined, these (1968), Sharpe (1966) and Treynor (1965) found
factors represent a significant hurdle that an active that, on average, active funds underperform their
manager must overcome just to break even with a benchmarks on a risk-adjusted basis and that the
low-cost index strategy over time. magnitude of underperformance directly relates to
the level of expenses.
Some studies support the notion that active funds
can sometimes outperform passive funds in less This debate about Active and Passive
efficient markets over certain down market Management is of constant discussion among
periods and sustained time horizons. individuals in the financial world. Thus, instead of
trying to find the winner the fundamental
A research report by State Street Global Advisors approach should be to ask: “How can I make the
and SPDR® ETFs for the 15-year period ended best decisions with respect to my goals and
December 31, 2010 found that more than 50% of objectives?”

Percent of Active Managers Outperforming Indices ~ 15-Year Annualized

Fixed Income 15%

Emerging Markets 42%

International 65%

Small Cap Blend 54%

Small Cap Growth 59%

Large Cap Blend 35%

Large Cap Growth 43%

0% 10% 20% 30% 40% 50% 60% 70%

Source: Morningstar Direct, SSgA Global ETF Strategy & Research as of 12/31/2010.


The decision to pursue passive or active management strategy should be decided based on understanding
your objectives by asking certain questions as shown in the figure below.

Do you believe
Do you believe that there are
that markets are some managers
generally who can
inefficient? consistently beat
the benchmark?

How comfortable Do you believe
are you with that you can find
taking on active these skillfull
risk? managers?

YES

ACTIVE MANAGEMENT


Passive strategies should be relied upon when your objectives, and understanding the factors like
the potential to beat the market is relatively poor taxes, fees and risk tolerance. The best investor
and to minimize tax liabilities related to capital would be the one who can identify market
gains. segments which are not efficient and employ
active strategies among those segments. In
Active Strategies should be pursued in those addition, one must identify superior active
markets which are less efficient and when you managers in asset classes where the manager has a
have high confidence. greater chance of outperforming.
You should make a decision as to which is the (Source: Passive and Active Management , A Balanced Perspective
correct and advisable strategy after accounting for Thomas Guarini, ETF Strategies, Global ETF Strategy & Research, State
Street Global Advisor)

We just saw the strenuous procedure involved Picking the right mutual funds is not an easy
into opting for passive or active management. task. There are qualitative and quantitative factors
Now the active investor needs to create a universe that need to be understood observed and more
of Mutual Funds to choose from. Creating this importantly analyzed correctly.
universe of funds involves tremendous skills in all
aspects. The active investor needs to have good
analytical as well as technical skills. Also
important are qualitative aspects like good
networking skills and having knowledge of
behavioral finance.

Manager Due Diligence
It is very important to perform diligence on the team changes every year. We would want the
company and its management, to know whether same management for at least 10 years. We
the management is engaged in costly litigation or need to evaluate how a manager has done in the
is involved in finding innovative ideas for the long-term. Why?
firm.
Short-term performance is of little use in picking
The performance of a mutual fund is largely a fund that you’re going to hold for the long term.
driven by the manager and his/her team. Funds with the top trailing one- and three-year
returns may continue well over the next short
Investment style, people, philosophy and term period, but may fare poorly over the long
performance are all carefully reviewed in the term.
manager search and selection process.
How big is the team? We prefer firms with a
The fund’s manager tenure period is looked at. strong team of analysts.
You would not want a fund whose manager and


How is the management team compensated? We expensive 20% of equity funds. (Source: Fund Spy by
are more interested in private firms, where Russell Kinnell)

managers receive ownership stakes in the firm. We review how managers performed in the past,
We want funds with at least enough assets under during bull markets and bear markets. We like
management because this will generate enough downside protection. Once a manager’s past
revenue to pay the salaries of good analysts and performance is understood, expectations can be
keep them for many years. set for future performance. These performance
We like for managers to have skin in the expectations and an investor’s tolerance for risk
game. We look at a manager’s ownership in his should be explicitly discussed and accepted when
or her own fund and like to see ownership valued selecting a manager.
at $500,000 or more. You wouldn’t like to see a Even after a manager is selected, constant
CEO who doesn’t own any stock in his own monitoring and reviewing is a difficult task.
company and for that reason we demand it in Unfortunately, ongoing manager review often
fund managers. becomes an afterthought or is not even discussed.
With regard to the fund’s portfolio, we want a low We review if a manager has closed a fund to new
turnover because it gives a low tax impact. investors in the past and ask how they decide to
close it in the future. Closing a fund means a fund
We want funds to have concentrated company is passing up fee income and hurting its
portfolios with fewer stocks. If the mutual fund own short-term profits in order to avoid letting
owns so many stocks, it may be better to just buy asset growth harm performance of the fund.
the index which is cheaper. We pay managers to
take risks. The managers selected should remain true to the
style and asset class for which they are being
What is the investment strategy? Funds that rely selected. A large-cap growth manager should not
on momentum strategies to buy hot stocks incur deviate drastically from his/her intended strategy.
greater trading costs than those more contrarian
Any change to the investment team should be
strategies that involve buying the stocks that
immediately reviewed. Changes to senior
everyone is desperate to sell. Like Warren
management or to the structure or ownership of
Buffett, we believe in buying stocks and
the firm should also be evaluated with a critical
holding it for the long-term.
eye as to their impact on the investment team’s
We prefer no-load mutual funds with low time, resources and capabilities.
expenses for several reasons. First, it shows that a
manager keeps business costs under control.
There is a high correlation between costs and
survivorship, as high-cost funds have a large
attrition rate. Second, fees reduce investor * People + Process + Philosophy = Performance *
return. When the cheapest 20% of equity funds is
compared to the cheap index fund, it is twice as
likely to beat the index as compared to the most


Bfm newsletter 10_2011

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